So investors who expect interest rates to decline might look for bonds or bond funds with longer durations or maturities to increase potential exposure to falling rates, whereas investors expecting rates to go up would prefer shorter durations or maturities to limit exposure to the higher rates. Longer-duration bonds and bond funds also typically have higher yields than their shorter-term counterparts to compensate investors for taking on added interest-rate risk.
The average effective duration figure also determines where the fund lands along the Interest-Rate Sensitivity axis of the Morningstar Fixed-Income Style Box, with ratings ranging from limited to moderate to extensive click here for more on how the Fixed-Income Style Box works. Measuring the Effect of an Interest-Rate Change Investors can use duration to help estimate how a bond or bond fund's value would be affected by a change in interest rates. This measure allows investors to easily make an apples-to-apples comparison of interest-rate sensitivity for bonds with different maturity dates and interest coupon rates.
For example, a bond with a duration of 6 years would normally be twice as sensitive to interest-rate changes as one with a duration of 3 years regardless of when they mature or what they pay in interest. Not a Perfect System Although duration can be a useful tool in determining the interest-rate sensitivity of a bond or portfolio of bonds, it is far from a perfect measure.
As Eric Jacobson, Morningstar's director of fixed-income research, points out in this article , duration is most useful in measuring interest-rate sensitivity for bonds that closely track U. In Market Research. Understanding the complexities of the bond market is important when evaluating the types of products and exposure a portfolio has within the asset classes of fixed income. In finance, both duration and maturity refer to different characteristics a bond may have. Clarification of the definitions should help those wishing to dive a little deeper into what may be subtle yet important difference among bonds whether looking at fixed income mutual funds, ETFs, or individual bond issues.
An example of this would be a movie with perhaps a duration of two hours or a roller coaster with a duration of one and a half minutes. A year Treasury Bond, as the name implies, matures or pays back its face value 30 years from its initial date. Investors are not obligated to hold the bond for the entire period as they have the option of being sold within the secondary market.
Individual investors or portfolio managers can buy or sell bond holdings to adjust the average maturity of the portfolio. Why would they want to do that? Generally speaking, the further out the maturity, the wider the potential price swings of the market value of the bond. That is a very important concept to bond investors, but it is a general concept as compared to an attempt at better detailing the relationship when we cover duration.
Keep in mind bond investors recognize two types of return, the first is the interest payment income which may be paid quarterly, semi-annually or even annually. If investing in a fixed-income mutual fund, interest payments are in the form of mutual fund dividends and may be paid monthly. Those payment cycles will play a role when duration is covered.
The second type of return is from price changes of the bond itself why maturity matters. This will help reduce the adverse impact of the Interest Rate increase on the Debt Fund.
You can use this same concept to select Debt Funds that are in line with your investment objectives. In that case, you can do so by increasing your investment in Debt Funds with a low Modified Duration of up to 2 years and decreasing your exposure to Debt Investments with higher Modified Duration.
A clear understanding of these aspects of Debt Mutual Funds can help you make informed choices regarding your Debt Investments so that you can optimize your returns while minimizing the overall risk to your portfolio.
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Since then, Flexicap Funds has emerged as the second most popu In this article What is Average Maturity? What is Modified Duration? There are many types of duration, and all components of a bond, such as its price, coupon, maturity date, and interest rates, are used to calculate duration. Here are some principles of duration to keep in mind.
First, as maturity increases, duration increases and the bond becomes more volatile. Second, as a bond's coupon increases, its duration decreases and the bond becomes less volatile. Third, as interest rates increase, duration decreases, and the bond's sensitivity to further interest rate increases goes down. This bond, following the basic bond pricing formula would have a market price of:. Next, using the Macaulay duration formula, the duration is calculated as:.
This result shows that it takes 2. With this number, it is now possible to calculate the modified duration. In this example that calculation would be 2. Fixed Income Essentials. Interest Rates. Corporate Bonds. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
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